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United States Vs. McGraw Hill: The Case For Efficient Markets

Written by: Kapitall02/07/13 - 12:40 PM EST

The stock market may not be perfectly efficient, but it is beautifully close. Monday, the S&P Ratings announced that they were anticipating being sued by the United States Department of Justice over their role in the financial crisis. S&P is part of the McGraw Hill conglomerate ( MHP). McGraw Hill&#39;s stock fell almost immediately about 13%. Yesterday, the Attorney General placed a number on the damages being sought, $5 Billion. Within hours, McGraw Hill had fallen another 5.7% on the news. McGraw Hill&#39;s total loss of Market Cap reached $2.7429 Billion by 12:00 pm on February 5 th, 2013, or 54.85% of the amount of damages being pursued by the Us Attorney General.

One could say that the market participants have given the US a 54.8% chance of winning; Or to be more precise since the courts can award partial damages, the market believes that court costs and damages will add up to approximately $2.75B for McGraw Hill. By market close on Tuesday, MHP had lost over 22% of its value, losing $3.75 Billion in market cap, an astonishing 75% of the total damages sought by the DOJ.

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The investment opportunity, for any who doubt the efficiency of the stock market, lies in speculating upon the outcome of the trial. A settlement for anything less than $3.75B should cause McGraw Hill&#39;s stock to appreciate, with a slight premium added in for the removal of uncertainty. A full victory for the Attorney General will cause McGraw Hill to fall by another $1.25 Billion.

A periphery investment opportunity arises from S&P&#39;s competitors, Moody&#39;s and Fitch. Moody&#39;s, a subsidiary of Moody Corp ( MCO), had shed $1.3 B in market cap within hours of Tuesday&rsquo;s announcement. By the closing bell, MCO was down over 17% in the last two days, losing $2.16B in market cap. Essentially, the market is giving Moody&#39;s a 43% percent chance of incurring the $5B liability mentioned by the Attorney General for S&P. This is essentially a 75% chance of S&P losing, and a 57% chance that if S&P loses, Moody&#39;s will also be brought to trial and lose.

These percentages may understate the market odds being given to Moody&rsquo;s. Moody&rsquo;s had revenues of $2.28 Billion in the last year. This is slightly more than a third of the $6.2B in revenues brought in by the McGraw Hill Companies. $5B would be crippling for MHP, but it would be catastrophic for Moody&rsquo;s. If the damages are proportionally adjusted by revenues, then the DOJ, if they sue MCO, should seek slightly more than $1.75B in revenues from Moody&rsquo;s. Moody&rsquo;s already lost more than that in market share. At times, investors are seized with fear and overreact. If this is the case, then the price of MCO will correct to reflect a more rational probability of incurring a liability, giving investors an opportunity to profit by buying MCO.